China, the International Monetary Fund (IMF), and interested think tanks have been pushing the idea of private SDR since the beginning of the year. It has now come to fruition. But what does it actually mean?

Initially, SDR-denominated bonds will be of particular interest to official investors, but gradually, they will also attract investors from private sectors.

— Zhu Jun, director general, PBOC

The so-called SDR is an IMF construct of real currencies, right now the euro, yen, dollar, and pound, without actually containing any of them. It is just a claim to demand payment in these currencies. It made news last year when the Chinese renminbi was also admitted, although it won’t formally be part of the basket until Oct. 1 of this year. The IMF and member countries trade the units currently worth $1.40 among each other.

“Initially, SDR-denominated bonds will be of particular interest to official investors, but gradually, they will also attract investors from private sectors. In such a way an SDR bond market will be developed,” Zhu Jun, the director general of the People’s Bank of China’s (PBOC) international department told Chinese business paper Caixin.

Worth Wray, the chief global macro strategist of STA Wealth Management agrees: “Right now there is no organic demand, but over a five-year horizon it could develop globally and maybe that creates another channel for capital to flow into China—if that’s the only market there is for it,” he said in an interview.

The SDR bonds issued by the two official institutions are different from the official SDR issued by the IMF. In fact, they are a derivative of it. When the World Bank unit called International Bank for Reconstruction and Development (IBRD) issues the bonds, it receives payment in yuan from the Chinese market or at first from the issue’s underwriter, the Industrial and Commercial Bank of China.

Chinese investors receive the SDR bonds, but what do they actually own?

For the Chinese investors, there is the advantage that they can hold a sizeable non-yuan denominated asset in China and reduce their risk to the Chinese currency.

Official SDRs can be redeemed for dollars, euros, yen, pound, and soon yuan through the IMF. However, the new private SDR, or M-SDR as the IMF calls them, cannot. The new bonds represent a claim on the IBRD. Since the IBRD doesn’t have any SDR assets, the repayment will also be in yuan, dollar, euro, yen, or pounds. So what’s the point of having this new basket?

For the IBRD, there is no advantage because it is borrowing in strong currencies and getting paid in a relatively weak one. For the Chinese investors, there is the advantage that they can hold a sizeable non-yuan denominated asset in China and reduce their risk to the Chinese currency, which may further fall in value. Because of still existing capital controls, buying foreign assets in size is not yet possible on the Chinese domestic bond market.

However, this is only an advantage for the time being. At the point of maturity, foreign currency will have to flow from the IBRD to the Chinese bond holders, unless they choose repayment in yuan, in which case the whole exercise would be rather pointless.

So given this lackluster value proposition, why are China, the IMF, and the U.S. controlled World Bank going out of their way to push the SDR into private markets?

Prominent market observers like James Rickards and Willem Middelkoop have long argued that the SDR will be the next world reserve currency. In fact, the current governor of the PBOC Zhou Xiaochuan has advocated for the SDR to become the next global reserve currency for a long time now.

“Special consideration should be given to giving the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency,” wrote Zhou in 2009. He also wanted the yuan to be included in the SDR, which is going to happen on Oct. 1. Take heed of his predictions.

It’s a geeky name but it’s a kind of world money printed by the IMF. They’ll flood the world with trillions of SDRs.

— James Rickards

“The Chinese … have made it very clear that the Special Drawing Rights of the IMF is the preferred future international world reserve currency,” writes Willem Middelkoop in a note to clients.

“What you are going to see is world money. You are going to see the IMF print Special Drawing Rights (SDR). It’s a geeky name but it’s a kind of world money printed by the IMF. They’ll flood the world with trillions of SDRs,” James Rickards told Epoch Times earlier this year.

Now that the first issuance is well underway, it is easy to lever up the balance sheets of international development organizations and keep issuing—or printing—SDR obligations even in the trillions until even private market actors support and accept them. Once the SDR is widely accepted as payment, the IMF could just redeem all outstanding local currencies for SDR and the world would not only have a new reserve currency, but just one global currency.

“You create new liquidity. That’s the kind of reform that could change the international system immediately,” says Worth Wray.

Willem Middelkoop says this could be done through an IMF substitution fund, an idea already discussed in the 1970s. “This fund could facilitate a direct exchange of dollars for SDRs. The liquidity issue would be resolved with one stroke of the pen, as an SDR would be created for every dollar that was exchanged,” he writes in his note.

Sounds crazy? It is, but the official plan is right here, for everyone to see.

Everything seems to be well in China, maybe except for the rising defaults. The currency is up almost a percent against the dollar for the last month and foreign exchange reserves only decreased by $4.1 billion, to $3.2 trillion. Long gone are the months of triple digit reserve drain during the turn of the year.

But underneath the surface the picture may not be as rosy.

“Our preliminary estimate of People’s Bank of China (PBoC) reserve operations suggests that net capital outflows amounted to some $39 billion in July, marking the largest net outflows in six months,” write the International Institute of Finance (IIF) in a report.

There’s a difference between having enough reserves to meet normal balance-of-payments needs and adequate reserves to defend resident-driven capital flight in a panic.

— Worth Wray, STA Wealth Management

So all the money that China made exporting goods, and then some, just stayed abroad. “We would not want to read much into a one-month pick up in capital outflows but we continue to caution that investor concerns about the policy environment andpace of economic growth will continue to influence the rhythm of capital flows to China,” the IIF states.

(IIF)

Worth Wray, the chief economist of STA Wealth Management, thinks there is a high risk that outflows could pick up again very soon. His premise is that while Chinese currency reserves are still high in absolute terms, and should be sufficient to finance trade, they will not last long if Chinese citizens lose confidence in the economy and move money abroad wholesale.

“There’s a difference between having enough reserves to meet normal balance-of-payments needs and adequate reserves to defend resident-driven capital flight in a panic. My point is that the buffers continue to fall and Beijing can’t keep following this policy course forever,” he told Bloomberg.

He compares the exchange reserves against deposits available in the banking system, made up of the savings of companies and citizens, also called the M2 money supply.

The ratio is now at its lowest level since 2003, according to Wray’s figures.

“We’ve seen an alarming fall in the ratio over the last few years. It was as high as 27 percent as recently as 2014—when FX reserves totaled more than $4 trillion—but is now closer to 14 percent. That’s well below the [International Monetary Fund]’s advisable 20 percent threshold,” he said.

(Source: Bloomberg)

In other words, while M2 is increasing—deposits in yuan can’t really leave China, it’s the owner who changes hands—because of new loan issuance, foreign exchange reserves are decreasing because citizens exchange the money for U.S. dollars and other foreign companies.

According to investment bank Goldman Sachs, Chinese residents buying foreign assets made up 70 percent of capital outflows during the last 9 months.

This estimate is consistent with survey data from FT Confidential Research. More than 60 percent said they are moving money overseas because of risk diversification and more than half expect the Chinese economy to slow further. A total of 56.8 percent of respondents said they will increase their investment overseas in the next two years.

(Source: FT Confidential Research)

The survey also confirmed the Chinese tendency to overpay for assets, as almost a third of respondents said they are looking for attractive returns overseas. It seems in their case, it is the return of their money, not the return on their money that counts:

Aaron Wu, a 31-year-old financial worker in Beijing, invested more than A$1m ($770,000) last year in a Sydney apartment and another A$240,000 in Australian shares after losing more than Rmb1.5m on the Shanghai stock market. The domestic stock market crash was a watershed moment for Mr Wu’s asset allocation strategy, he said.

China has tried to counteract this trend by making moving money abroad more difficult and 67.6 percent of the respondents say it has become harder to circumvent the $50,000 limit.

According to Assia Nikkei review, the PBOC has told banks in a private meeting last month to clamp down in international transactions but didn’t make new regulations official.

And it’s not just the citizens moving money abroad. Companies, whose deposits are included in the above M2 analysis, are also buying foreign assets to the full extent of the law.

Chinese companies bought a total of 493 foreign firms for $134.3 billion during the first half of the year, according to a report by PriceWaterHouseCoopers (PwC) cited by ChinaDaily. This is an increase of almost 350 percent compared to the same period last year.

Contrary to its citizens, the regime is encouraging companies to take over foreign firms, following the Chinese premier’s Li Keqiang’s “going out” policy.

“The outbound M&A is an irreversible trend in the long term,” Liu Yanlai of PwC states in the report.

One thing is for sure, the Chinese yuan just had its worst drop on record ever since the last currency in 1994. The yuan lost 2.9 percent against the dollar since the end of March to 6.64 on June 30.

Another sure thing: Brexit didn’t help as the yuan devalued almost one percent in a single day on the Monday after the historic vote. This is where the certainties end and where speculation and confusion starts.

Performance of the Chinese yuan (Bloomberg)

It is speculation that China used the cover of Brexit to ease renewed pressure from capital outflows, which ebbed off to $20-$30 billion per month after $100+ billion run-rates in the first two months of the year. The 1 percent drop on Monday took the currency close to six year lows and could have been a welcome opportunity to do this, as everybody else was watching how markets in Europe reacted to the Brexit. Before, China’s currency has been dominating headlines and global markets since the first surprise devaluation in August of last year and any sharp devaluation was not received well.

On the other hand, traders could have just taken some risk off the table because of the global spike in volatility. Another indication that the Chinese currency will enter the safe haven status anytime soon.

On the policy side, things are even more confusing. Despite the steep drop and relative volatility, Chinese state newspapers want the world to believe that there is no pressure on the currency. “Although the yuan’s mid-point fell against the U.S. dollar on consecutive days, the mood in both on-shore and off-shore markets is basically stable with no signs of panic-selling or a scramble for foreign currencies,” the Shanghai Securities News reported, citing industry experts as saying.

Panic selling is a vague term and may be more applicable to the British pound, but stability in the onshore and offshore yuan markets also looks different.

Although the regime is maximizing for stability, it doesn’t mind that Reuters quotes other government economists later in the week who claim the central bank would be happy to see the yuan at a rate of 6.8 per dollar. “The central bank is willing to see yuan depreciation, as long as depreciation expectations are under control,” Reuters cites unidentified sources.

As the yuan takes further steps to become a global currency, the ways in which Chinese and foreign governments, banks, and corporations plan to use the currency are becoming clearer.
The bond market received a jolt last week, as South Korea declared it would become the first sovereign issuer of yuan-denominated bonds—a.k.a. panda bonds—in China’s onshore financial markets. The three billion yuan ($465 million), three-year bond could close as soon as Tuesday, Dec. 16.
The announcement comes two weeks after the International Monetary Fund (IMF) decided to include the Chinese yuan in the basket of reserve currencies backing its special drawing rights.
Korea Dives In
South Korean government officials marketed the bonds to Chinese investors in Shanghai and Beijing this month. “The Korea and Shanghai stock exchanges agreed to research to link stock and bond trading as a longer term project,” according to the Korea Exchange in a statement.
Korean officials say that the issuance should serve as a pricing benchmark for Korean companies looking to issue debt in China going forward. China is South Korea’s single biggest trading partner.
Other governments are also close to issuing panda bonds. Canadian province British Columbia—home to half a million of ethnic Chinese—is also contemplating onshore Chinese bonds. The province received Beijing’s approval for up to a six billion yuan issuance.
Financial Institutions Take Lead
The International Finance Corp., a unit of the World Bank, and Asian Development Bank issued the first panda bonds in 2005, raising a combined 2.2 billion yuan ($350 million).
China’s $6.8 trillion onshore bond market—the world’s third largest behind the U.S. and Japan—could be an important funding source for banks and companies doing business in China.
But bond issuances have been muted, with a total of $1.8 billion raised in the panda-bond market to date, according to Dealogic, a financial software company. Outside of those international financial institutions, German automaker Daimler AG was the only other issuer, with a 500 million yuan private placement in 2014.
MORE:China’s Offshore Yuan Spread Heightens Expectations of Further Currency Devaluation
It’s not for lack of trying. China’s bond market has been largely closed off to foreign issuers. The People’s Bank of China (PBoC) and a slew of other regulatory bodies first drew up the rules in 2005, which had extremely strict requirements on what type of institutions were allowed to issue debt in China. Those rules are being loosened today as Beijing looks to boost investments and promote international use of its currency.
On Dec. 8, the PBoC gave approval to two Hong Kong-based financial firms, HSBC and Bank of China (Hong Kong), to issue 1 billion yuan and 10 billion yuan, respectively, in panda bonds.
“The central bank’s approval for one of the first issuances of its kind by a foreign financial institution could signal the opening up of an alternative source of funding,” Helen Wong, HSBC’s chief for Greater China, said in a statement.
Chinese regulators began lifting restrictions this year. In July 2015, the PBoC announced that foreign central banks, sovereign wealth funds, and other multinational financial firms would no longer need the central bank’s preclearance to invest in China’s interbank debt market, such as trading bonds, interest-rate swaps, and repurchase agreements.
That announcement later paved the way for foreign financial firms to issue bonds in China’s panda bond market for the first time.
Panda Versus Dim Sum
Why is Beijing just now opening the panda bond market to foreign firms? Yes, it will give its currency more international exposure, but another major reason is to boost China’s economy.
Approval of the banks’ panda bonds comes at a time of turmoil in Chinese financial markets. The Shanghai Composite Index, China’s biggest equities benchmark, has dropped almost 40 percent since peaking in June, while the country’s 10-year government bond yield has declined from 3.66 to 3.30 percent.
Confidence in the nation’s economic growth is floundering, with unofficial third-quarter GDP growth estimated to be between 2 to 5 percent. The PBoC cut interest rates five times in the last twelve months to spur growth.
This is a prime environment for multinational companies looking to issue yuan-denominated debt. Previously, firms seeking to sell yuan-denominated bonds looked to the offshore market, specifically in Hong Kong, which saw a huge uptick in yuan bond offerings after Beijing approved channels for capital flow between Hong Kong and Shanghai last year. These offshore yuan bonds are referred to as dim sum bonds.
Analysts believe such dim sum issuers are prime candidates to jump into the panda bond market going forward. “It’s very similar to the initial stage of the dim sum market when we saw a lot of interest from issuers trying to be the first ones to issue, mostly because of positive publicity,” Ivan Chung, head of Greater China credit research at Moody’s, told Global Capital.
The key to panda bonds taking off is whether China will lift capital flow restrictions, by allowing firms to redeploy debt proceeds abroad.
“The dim sum market, for example, that is mostly an arbitrage market in which most issuers will swap the proceeds back to U.S. dollars and redeploy them offshore,” said Chung.
“It’s unclear with the proceeds from a panda bond whether that is possible because of the tight capital controls.”
For multinational corporations, it’s cheaper to issue directly in China than Hong Kong. For China, a surge in panda bonds provides more liquidity, diversification for investors, and higher revenues for local Chinese governments and investment banks. More importantly, it’s another feather in the cap for boosting Beijing’s global yuan ambitions.
As such, experts believe that capital flow controls will be relaxed sooner rather than later. The PBoC expects to release more detailed guidelines by end of the year. Both HSBC and Bank of China (Hong Kong)’s panda bond prospectuses state proceeds would be deployed overseas for foreign operations.
If that’s the case, it could be a death knell for the dim sum market in Hong Kong.
And that is bad news for the city’s financial sector, the overall CNH (offshore yuan) market, and the foreign banks—many of which were urged by Chinese authorities to help develop the Hong Kong offshore yuan market years ago.

China’s currency tumbled in offshore trading last week to its lowest level in a month, as traders speculate that further monetary easing may be in store after disappointing economic growth readings last week.

The offshore yuan (CNH) declined to 6.39 per dollar, compared to 6.35 per dollar for the onshore currency (CNY), on Oct. 23. That’s a spread of around 400 basis points, the biggest in more than a month.

CNY represents money traded within China and under its tight currency fix restricted to a 2 percent maximum movement per day. CNH yuan, which trades outside of China and is more free-floating based on supply and demand, is usually viewed as a truer picture of the yuan’s worth.

The existence of this CNH-CNY gap is one of the reasons the International Monetary Fund has been reluctant to include yuan in its currency basket.

While China’s official third-quarter GDP reading of 6.9 percent was higher than expected last week, independent analysis pegs that rate much lower based on consumption and spending figures.

China’s decision to cut interest rates once again last Friday was a smoking gun that the economy may be weaker than reported. The interest rate was cut by 25 basis points, the sixth time the People’s Bank of China (PBOC) has lowered rates in the last year.

China also slashed its banks’ reserve requirement ratio, allowing more credit to enter the economy. The decision was due to increased downward pressure on the nation’s economy, according to a statement on the PBOC’s website.

Removing Rate Cap

Along with rate easing, Beijing also removed rate caps on bank deposits.

This move is an easy one, and helps on two fronts. It lifts the savings rate ordinary households earn on their bank deposits, which increases household wealth.

Two, it can create more competition among Chinese banks, particularly the smaller ones. Higher interest payouts also encourage banks to lend to small and medium-sized businesses, whereas in the past money tended to channel to large, state-owned enterprises.

Currency Devaluation Fears

The latest interest rate cut increased the likelihood that capital flight from China would accelerate as foreign deposits become more attractive.

Last Friday J.P. Morgan analysts estimated that capital outflows during September were between $130 billion to $140 billion. Estimates by Bloomberg, which count dollar holdings by exporters and direct investment recipients, are closer to $194 billion.

Such pressures to sell the yuan, coupled with investor speculation that the PBOC may devalue the currency further in the face of weak economic growth, have sent the yuan tumbling in offshore markets.

Earlier in the month, asset manager PIMCO wrote that it expected further yuan devaluation by the Chinese central bank.

“We expect private capital expenditures and property prices to weaken further, risking a negative spillover to employment and consumer spending. We expect to see a significant monetary policy response from the People’s Bank of China,” PIMCO wrote.

If offshore yuan trading is any indication, a monetary policy response may be imminent.